If you’re considering your borrowing options, then comparing the APR of personal loans and credit cards is important. It gives you an estimate of how much borrowing will cost, including interest and additional charges like the annual fee.

But what exactly is an APR? And how can it affect your borrowing? The key things to know when looking at APR are how it’s applied and how it’s calculated. Let’s break this down.

What is APR?

‘APR’ stands for ‘annual percentage rate’. It’s an estimate of the yearly costs of a personal loan or credit card including interest and compulsory charges. Lenders have a legal requirement to state their APR to potential borrowers before they agree to a loan or credit card.

APR doesn’t include optional charges like penalty charges for late payments or breaching your credit limit.

How does APR work?

APR works by providing an estimate of what interest and additional fees you’ll pay, like application fees and annual charges. This gives you an easy way to compare different lenders and work out which is likely to be the cheapest.

For example, if you want to borrow £10,000 at an APR of 10%, then the loan will cost you around £1,000 per year. The actual cost could be a little higher or lower depending on how fast you pay off the loan and whether you incur any charges.

How is APR calculated?

APR is calculated by adding together the annual interest rate payable on an outstanding balance and additional fees payable.

APR is used to calculate how much interest you pay on a loan or outstanding credit card balance. For example, if you owe £5,000 on a credit card with an APR of 20% and no additional fees, your interest will be calculated daily using the APR. It is worked out as 20%/365 x £5,000. That means you’ll owe an extra £2.74 per day.

If your lender charges an annual fee, then this will be included in the APR. For example, if you owe £10,000 on a personal loan which is payable over two years and the lender charges an annual fee of £100, an arrangement fee of £200 and annual interest of 5%, the total cost per year is £700 (£500 interest plus £100 annual fee + £100, half of the arrangement fee). This means that the APR would be 7%.

What’s not included in APR?

APR is only an estimate of the yearly cost of borrowing. That’s because it doesn’t include certain non-compulsory borrowing costs like penalties for late payments or going over your credit limit.

APR also doesn’t include additional interest costs caused by something called interest compounding. Interest compounding means that you’ll often pay more interest over time than the APR.

Interest compounding means that interest gradually builds up over time if you don’t clear your balance. For example, if you owe £10,000 at an APR of 24%, that means you will be charged monthly interest of 2%. So, assuming you don’t pay off the loan, a month later you will owe £10,200. The following month, interest is calculated on £10,200 rather than the original £10,000, so the interest charged will be slightly higher. Most credit cards calculate interest daily, so this compounding has an even bigger effect.

Representative vs. Personal APR: what’s the difference?

Representative APR is the advertised rate of APR. This is actually only offered to 51% of customers. That’s because lenders individually assess each application before deciding what APR to offer.

Personal APR is specific to each borrower. It’s the rate you’re offered once a lender has processed your application. Lenders look at your credit score and your personal circumstances before deciding what APR to offer. If you have a poor credit rating, then your personal APR may be higher than the representative or advertised APR.

What’s a good APR for a credit card?

The APR on credit cards and personal loans varies significantly. Credit card APR rates are usually between 5% and 30%, depending on the lender’s eligibility criteria and your credit score.

Some credit cards offer an initial 0% interest period on purchases or balance transfers. Make sure you keep track of when your balance needs to be paid off so you don’t get hit with an unpleasant surprise!

The APR on cash withdrawals may be different to the rate for making purchases. Take a look at your terms and conditions to check.

If you’re looking for a credit card with a good APR, then check out our list of top-rated credit cards for 0% APR on new purchases in the UK to find the right one for you.

The post What is APR and how does it work? appeared first on The Motley Fool UK.

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